How many factors are driving euro’s descent?

The euro’s value is falling conspicuously. Compared with the highs in the last quarter of 2009, Europe’s unified currency has dropped from around ¥135 to ¥122, and from about $1.52 to roughly $1.37, losing nearly 10 percent against the yen and the dollar. What is causing its fall and where will it go from here?

The first of the several causes behind the euro’s decline is the political trouble in the euro-zone economies. The cost of guaranteeing loans against default has risen sharply in light of the rising risk being attached to Greece’s snowballing sovereign debt. European Union leaders said Feb. 11 that they would support Greece’s fiscal reconstruction efforts and pledged to “take determined and coordinated action, if needed, to safeguard financial stability in the euro area as a whole.”

This message promising all-out action to maintain trust in the common currency gave the EU’s leaders some breathing space, but the fact remains that it will be tough to implement the Greek government’s plan to bring its debt-to-GDP ratio from 12.7 percent in 2009 to 8.7 percent in three years. Spain and Portugal face similar problems, and even Germany and France have budget deficits that exceed the EU’s common standards.

The European Union announced on Feb. 12 that the gross domestic product of the euro-zone economies grew 0.1 percent in the October-December quarter, marking two consecutive quarters of expansion. But GDP growth in July-September quarter was 0.4 percent, and this suggests the EU economy is losing steam.

While France led the region with 0.6 percent growth, Germany — the largest European economy — posted zero growth, while Greece and Spain contracted 0.8 percent and 0.1 percent, respectively.

The second factor behind the weakening euro is the continuing impact of the Dubai Shock.

This issue hasn’t been covered that much by the Japanese media recently, but major European banks with huge exposure to Dubai are being hit by rising nonperforming loans that are lowering their capital adequacy ratios. This has in fact contributed to a worldwide slump in the value of bank shares, and both the Nikkei index in Tokyo and the Dow average in New York are barely staying above 10,000, reflecting a renewed flight from risk.

The third factor affecting the euro is declining tax revenues from global economic woes and the subsequent rise in budget deficits.

European Central Bank chief Jean-Claude Trichet has defended the EU’s situation by stating that the euro zone’s budget deficits are within 6 percent of GDP on average, and that the region is in much better condition than the United States and Japan, whose deficit-to-GDP ratios have ballooned to double-digit figures.

Budget deficits have become a common challenge to all industrialized economies, limiting their economic stimulus options. The Group of Seven finance ministers and central bank chiefs who gathered in Canada earlier this month agreed that efforts need to be maintained to keep the global economy afloat while addressing this problem. But it is obviously difficult to chase both goals at the same time.

Japan has ¥774.2 trillion in ordinary national government bonds outstanding, and its total long-term debt — including that incurred by local governments — has soared to ¥1.326 quadrillion.

The fourth element the euro must reckon with is the course of interest rates, which could affect its future prospects. Exchange rates fluctuate mainly for two reasons — national external balances and interest rate gaps with other economies.

The euro-zone countries as a whole do not hold huge external deficits. The biggest question is whether money will continue to flow into the United States — which is running a current account deficit.

The key here is interest rate differentials, which determine returns on investment. One factor driving the euro’s depreciation is the prediction that lingering economic uncertainties will force the ECB to spend more time than the U.S. Federal Reserve in raising interest rates. Japan, with its falling prices, is expected to be the last of the major economies to bring interest rates higher.

The current trend in the foreign-exchange market is likely to continue for some time, but given Japan’s real economic conditions, low interest rates and the size of its fiscal debt, the yen will probably face downward pressures in mid-2010, when the industrialized countries are likely to start seriously discussing their exit strategies.